The Unfairness of the Buffett Tax

A hike in the capital gains rate would be more a tax on the old than a tax on the rich.

According to a recent poll, nearly two-thirds of us agree that the idea of hiking tax rates on rich people would be fairer to the non-rich taxpayers. But how many of us would favor a proposal to hike taxes on old people instead of rich people—that is, on gramps, granny, and their fellow retirees in the middle and lower income classes? Specifically, how would the poll results change if we knew the Buffett rule would have those unintended effects?

In theory, it’s about fairness

According to proponents of the Buffett rule, it’s all about fairness. It’s about the “principle” that Warren Buffett, Mitt Romney, and their rich peers should pay an effective tax rate at least as high as their secretaries’ effective rates. This “principle” almost certainly means that solving the alleged problem of Buffett’s too-low effective rate would require a significant hike in the tax rate on capital gains. More specifically, the tax would phase in a minimum tax for those with incomes of $1 million or more, until those making at least $2 million would face a mandatory minimum 30 percent tax.

Obviously, voters are the target audience of this fairness message—even though taxation can only become “fairer” for those who actually pay taxes. Many voters are non-taxpayers, a category that increased in size as a result of the Bush tax cuts—which not only cut everyone’s tax rates, but increased significantly the proportion of tax filers who actually paid zero or negative income taxes. The obvious goal of any political campaign is to influence voters, not just taxpayers, and emotional appeals almost always work best. It is therefore no surprise that tax-rate fairness has been selected as a campaign centerpiece.

Perhaps that is a mistake, however, because emotions can work both ways—especially when the law of unintended consequences is in play.

Because those retirees won’t have the power to time their capital gains as the truly rich do, they’ll have little choice but to pay the higher tax.

Only a few recently polled voters seem to mind extracting more money from the rich. After all, paying a little extra wouldn’t hurt them, would it? At first glance, it seems as if nobody would get hurt. Tagging “the rich” for the higher rate sounds much more appealing than, for example, a proposal to single out gramps and granny for a new tax. (Two years ago, we certainly didn’t like watching a wheelchair-bound granny get shoved off a cliff during the healthcare debate—so why wouldn’t we be equally offended this year by watching her become the victim of a purse-snatching?) Surprisingly, if our experience with capital gains taxation is any guide, the Buffett rule could turn out to be just that: An unpleasant surprise for many older people when they retire.

In practice, it hasn’t worked as intended

As Alan Reynolds noted last year in his testimony to the Senate Finance Committee, the truly rich already have sufficient resources to wait out a capital gains tax rate they consider too high; in other words, they can easily decide not to take their capital gain until they think the tax rate is at an acceptable level. And when the rich decide to delay the selling of assets that have gained in value, they don’t pay any capital gains tax at all, no matter what the tax rate is. It has happened again and again: tax revenues from capital gains have consistently gone up whenever the tax rate went down, and vice-versa—and the timing power of the rich is the reason why.

Second, and more importantly: Who does that leave bearing the burden of the new, higher tax rate? It leaves those who are not rich and therefore do not have the resources to “wait it out” as the rich are able to do. It leaves the elderly non-rich, whose plans for retirement income depend on a one-time cashing in of the savings they’ve built up in small businesses, houses, stocks, and bonds during their working lives. Many of them will retire soon, and will incur a one-time surge in their incomes when they cash in the assets they saved up; that one-time surge makes them appear to be one of “the rich” to IRS computers. Because those retirees won’t have much of a choice, i.e., they won’t have the power to time their capital gains as the truly rich do, they’ll have little choice but to pay the higher tax on the capital gains they had counted on for their retirement years. Any hike in the gains rate will hurt them.

The law of unintended consequences strikes again

Tagging ‘the rich’ for the higher rate sounds much more appealing than, for example, a proposal to single out gramps and granny for a new tax.

That scenario is the unintended consequence of the Buffett rule: Poor old gramps and granny would pay the higher tax, if they had saved up a million or more in assets to cash in for their retirement years—not the truly rich with consistent incomes of a million or more every year. Ironically, the tax rate on capital gains would be higher, the revenue would be lower, and the truly rich, because of their timing power, would pay less, not more, in capital gains taxes.

Experience tells us that the old have paid in the largest portion of the government’s capital gains take—typically for those one-time events such as the sale of a house or a business around retirement time. In contrast, the truly rich tend to hire experts to make sure they are lawfully minimizing their tax exposure year after year, even when that means delaying capital gains until the tax climate is more favorable.

In short, a hike in the capital gains tax rate would not be as much of a tax on the rich as it would be a tax on the old. It would be the consequence of ignoring decades of experience with changes in capital gains rates: Instead of soaking the truly rich as intended, Uncle Sam would, in effect, be taking a bigger bite out of gramps’ and granny’s nest egg.

What started out as a fairer-sounding Buffett rule would have turned out to be a comedy of errors—but none of us (besides a few politicians) would be laughing. Our response to the proposed Buffett rule should be, “Nice try, but no thanks; Granny will pay enough from her nest egg as it is.”

Steve Conover retired recently from a 35-year career in corporate America. He has a BS in engineering, an MBA in finance, and a PhD in political economy.